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Comment on “Will Chinese revaluation create American jobs?” by Evenett and Francois

Joseph Gagnon30 April 2010

This column argues that a 10% revaluation of the Chinese currency would likely increase US employment by at least 670,000. This is in stark contrast to recent Vox contributions by Simon Evenett and Joseph Francois claiming that an appreciation of the Chinese currency would reduce US employment by 400,000 to 600,000 jobs.

The recent column on this website by Evenett and Francois (2010)[1] and the associated article by Francois (2010)[2] claim that a 10% revaluation of the Chinese currency is likely to reduce US employment by 400,000 to 600,000. I believe that this conclusion arises from modelling errors. A correct implementation of the underlying model would yield an increase in US employment of at least 670,000.

The first modelling error is simply that Evenett and Francois assume that US GDP is fixed and does not respond to exchange rates. Such an assumption may be reasonable for long-run analysis when economies are at full employment, but it is clearly unrealistic in the present circumstances in which US GDP and employment are far below potential and expected to remain below potential for several years. In standard macroeconomic models, when monetary policy is constrained at zero interest rates, the $100 billion increase in net exports that Evenett and Francois predict would increase GDP by more than $100 billion as the extra income and production stimulated additional consumption and investment (see for example Bodenstein et al. 2009, who show that the effects of foreign shocks are larger when monetary policy is at the zero bound. Their result is based on a dynamic stochastic general equilibrium model).

The second modelling error arises from the way Evenett and Francois endogenised employment. In their standard model specification, employment is fixed, which is consistent with the assumptions of fixed capital and fixed GDP. The real wage rate is then given by labour’s share of output divided by employment. In the version of the model used for this analysis, real wages are fixed and employment is determined by labour’s share of output divided by the real wage. Higher import prices reduce labour’s share of output. Given a fixed real wage, employment must decline. But that result is nonsense.

How can output remain fixed when capital is fixed and employment and imported inputs are declining? The problem is that the model does not contain a production function based on capital, inputs, and labour. Moreover, the assumption that real wages are fixed is the wrong assumption to make in the current environment. Fixed nominal wages are more appropriate. With fixed nominal wages, it would take only a small increase in US output prices to encourage a major shift by US firms away from more expensive imported inputs toward US workers.

Evenett and Francois point to what they say is a “similar finding” to theirs by Fair (2010). In fact, there is little in common between the two results. Unlike Evenett and Francois, Fair finds very small effects on both the US trade balance and US employment from a Chinese revaluation. Fair assumes that the Chinese revaluation reflects contractionary monetary policy. It is a standard result that monetary policy has little spillover to other countries because the domestic demand and relative price effects operate in opposite directions in approximately the same magnitudes. In Fair’s simulation, Chinese GDP and prices fall steadily below baseline for more than 8 years, causing a drag on foreign activity that roughly offsets the stimulus from depreciation against the renminbi. Of course, no one is asking the Chinese to throw their economy into recession. Indeed, the problem in China now is one of overheating and the Chinese are taking steps to cool off their economy. A currency revaluation that shifts net demand overseas is a much better alternative than slowing the Chinese economy by reducing domestic demand. Thus, Fair’s simulation ignores the actual policy choice China faces.